Bank regulation, supervision and liquidity creation

Abstract

The exposures of the banking system during the global financial crisis of 2007–2009 alerted regulators who strengthened their regulation and supervision of banks to prevent future problems. Yet, banks need to perform one of their main functions in the economy, which is creating liquidity. This raises the question: does greater regulation and supervision of banks enhance or impede bank liquidity creation? We use the 2019 Bank Regulation and Supervision Survey published by the World Bank to update the respective indexes and examine the relationship between regulation, supervision and liquidity creation. We find that banks create more liquidity in countries with stronger supervision policies such as supervisory power and mitigation of moral hazard, while they create less liquidity in countries with tighter regulatory regimes such as activity restrictions and capital regulations.